The due date for comment letters on the proposed Volcker Rule has now passed. The comment letters are interesting for a variety of reasons. (I had the benefit of seeing draft versions of several of the comment letters, and I’ll just say that I’m amazed at the level of convergence they were able to achieve between the industry letters — both substantively and stylistically.)

Instead of trying to write a single, lengthy post with all my analysis of the competing arguments — an undertaking which I simply don’t have the time to complete — I’m going to sort of provide analysis as I go.

In my first post, I’m going to do something which, in my professional capacity, I never get to do: make predictions. I do this without any inside knowledge or the regulators’ thinking, and with full awareness that it’s far too early to know exactly what the regulators will do. But if you don’t make firm predictions, then how are you supposed to say “I told you so” when you end up being right? With that in mind, here’s what I think will ultimately happen to a few of the key portions of the Volcker Rule:

1. The requirement that market-making activities be “related to clear, demonstrable trading interest of clients” will be completely scrapped. The industry will win this one, and for good reason. The “clear, demonstrable trading interest” standard is simply inconsistent with the statutory text, which permits market-making activities that “are designed not to exceed the reasonably expected near term demands of clients.” Client demand can be “reasonably expected” well before the demand is “clear” and “demonstrable.” The statute permits market-making desks to trade in anticipation of “reasonably expected” near-term client demand, so applying a “clear, demonstrable trading interest” standard would be plainly inconsistent with the statute.

To be honest, I don’t think the regulators ever truly intended to apply this standard. The language about market-making activities being “related to clear, demonstrable trading interest of clients” was included in the criterion for bona fide market making, and NOT in the criterion for “reasonably expected near-term demands of clients,” which was far broader. It’s probably a fair bet that different people wrote those two sections, and they were never properly reconciled before the regulators published the proposed rule. However, I also think that the criterion for “reasonably expected near-term demands of clients” will be broadened as well. While that criterion is broader than the “clear, demonstrable trading interest” standard, there’s still a reasonably strong argument to be made that the language in that criterion is too narrow, and doesn’t reflect congressional intent.

2. Regulators will keep the market-making exemption in the proposed rule, but will add a broader “alternative” market-making exemption that relies more heavily on trading metrics to identify prohibited prop trading. Admittedly, this one is a longshot. The industry wants the regulators to replace their current market-making exemption with a much broader exemption, described in the main SIFMA/Clearing House letter:

“We believe a business should be viewed as customer-focused, and therefore engaged in market making, to the extent it is oriented to meeting customer demand throughout market cycles. This can be evidenced by, among other activity, a focus on offering execution to customers, building relationships with customers and providing sales coverage, providing research to customers and participating in the interdealer market in order to serve customer demand.”

Now, this is clearly way too broad. But it does have the benefit (and, from the regulators’ perspective, the attraction) of being simple and inclusive enough to serve as a uniform standard of market-making across all asset classes. If the regulators press on with their current definition of market-making, which contemplates different standards for each different asset class, then the regulators will be drawn into endless battles over what constitutes permitted market-making in every single asset class and market. That’s a daunting task, and I can’t imagine that the regulators are looking forward to writing 50 different, customized definitions of permitted market-making. I’m sure a simple, uniform definition of market-making for all asset classes will look pretty appealing.

However, because the definition of market-making that SIFMA et al. propose is clearly far too broad (sorry guys, but “providing research to customers” ≠ market-making), the regulators will still need some other, non-definitional way to identify prohibited prop trades. And that’s where the trading metrics come in. The proposed rule already identifies several quantitative metrics that can be used to reliably distinguish between market-making and prop trading, and can also be used across the different asset classes.

I think the bargain that the regulators will end up striking here is to add a broader, uniform market-making exemption that relies heavily on quantitative metrics as an alternative to the market-making exemption in the proposed rule. This alternative market-making exemption would obviously have to be narrower than the definition that SIFMA et al. propose, but would still be broad enough to encompass all legitimate market-making across different asset classes.

3. The “trading account” exemptions will stand. The proposed rule excludes repos, securities lending, and positions taken for bona fide liquidity management from the crucial definition of “trading account” — which effectively means that those positions are exempt from the Volcker Rule’s prop trading ban. While Merkley and Levin (amusingly) tried to argue in their comment letter that there is “no statutory basis” for these exclusions, they failed to offer any, you know, actual evidence for their claims. That’s usually fatal to an attempted legal argument. The group “Occupy the SEC”1 even tried to describe various scenarios in which banks could exploit the “trading account” exemptions to put on prop trades, but their examples tended to be inaccurate (in that they would not have legitimately circumvented the prop trading ban), or ultimately irrelevant.

At best, I think the repo and securities lending exemptions might be slightly revised to include an explicit “anti-evasion” clause. But past that, I think all three “trading account” exemptions will stand.

4. The regulators will issue a re-proposed Volcker Rule rather than a final rule. I think the changes will ultimately be too significant to go straight to a final rule, and that regulators will want another notice-and-comment period to get feedback on any changes.

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1 While “Occupy the SEC” should certainly be commended for engaging in the rulemaking process (which is where all the real action is), and for engaging in a substantive manner, I don’t think their Volcker Rule comment letter was terribly persuasive on any major point, and I don’t think it will ultimately result in many (or any) substantive changes to the final rule. Now, a lot of the letter’s problems were the result of this clearly being the authors’ first time writing a comment letter to banking regulators. So allow me to offer some constructive criticism (since I imagine there will be another notice-and-comment period for the Volcker Rule): For one thing, the letter contained far too many sweeping, conclusory statements, for instance about what did and did not contribute to the financial crisis, and these sweeping statements too often served as the sole basis for the group’s desired change. Regulators are not responsive to those kinds of arguments, to say the least. (In general, “a guy I read on Huffington Post said X contributed to the financial crisis” is not a winning argument at this level.)

Occupy the SEC’s letter also spent far too much time making tangential arguments that were often based on a simple misunderstanding of the proposed rule, which is a great way to kill a letter’s credibility and undermine its more legitimate arguments. Lehman’s use of Repo 105 was a scandal, but not one that was relevant to the proposed Volcker Rule. It’s absolutely imperative that you pick your battles in these comment letters — focus on the truly meaningful debates, and emphasize your strongest arguments. Also, your audience is the regulators, not other activists, so tone down the self-righteousness. Big-time. Regulators are professional civil servants, so they’re hardly responsive to letters that lecture them about their duty to the public.

About Me

I'm a finance lawyer in New York. I used to focus on derivatives and structured finance (you know, back when there was a structured finance market). I spent the majority of my career at one of the major investment banks. My background is in economics and, unfortunately, politics.

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